Asset Management ADVocatehttps://www.assetmanagementadvocate.com
Unique Views into the Regulation of Asset ManagementFri, 15 Sep 2017 15:36:23 +0000en-UShourly1https://wordpress.org/?v=4.7.7Family Offices and the Madness of Crowdsaleshttp://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/AlFwqAa30C4/
Fri, 15 Sep 2017 15:36:23 +0000https://www.assetmanagementadvocate.com/?p=1421Continue Reading]]>Recently, I have had an opportunity to review many “tokens” that can be transferred over the Ethereum blockchain and used for various “smart contracts.” Depending on their facts and circumstances, certain kinds of tokens being sold in so-called “initial coin offerings” were the subject of a recent SEC Section 21(a) report. I have also seen correspondence from family offices seeking to participate in these token offerings, in some cases before the developer has fully worked out the token. This raises a concern that a family office may wound itself trying to get in on the “cutting edge” of this new way to disseminate technology.

The 21(a) Report

The SEC issued its report in response to the increasing use of:

distributed ledger technology to offer and sell instruments such as [a particular kind of tokens] to raise capital. These offers and sales have been referred to, among other things, as “Initial Coin Offerings” or “Token Sales.”

The report stressed:

that the U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.

Thus, unless the tokens are properly constructed and their sale is properly conducted, selling tokens that are freely transferable on a distributed ledger may violate federal and state securities laws.

Fiduciary Concerns

Issuance of the 21(a) report has led purchasers to focus on whether a token would be a “security” as defined by the SEC. For a family office or other investment adviser, unless the client intends to use the token to obtain a product or service, the first question must be whether a token, if bought for investment purposes, would be a sound investment. Until we can gauge the effects of the SEC’s report, “caveat emptor” are the watchwords and heightened diligence is called for.

Most tokens are described in so-called “white papers.” The focus of the white paper tends to be describing what the newly invented technology does and how it can remove inefficiencies in human interactions and change the world for the better. These white papers should be scrutinized to determine whether developers have set forth a viable business plan, including demonstrating a focus on demand and/or a detailed marketing plan. In the current market, a fiduciary must make sure to find and review the information necessary to exercise reasonable care in recommending investments in a token. Indeed, many developers want to sell their tokens only to potential users, so their terms and conditions insist that you not buy the token for investment.

Legal Concerns

An investor may accept the risk of an asset’s value falling to zero, but few wish to take on additional liability. In this regard, it is worth noting that the risk of a token being a “security” is not limited to the developer of the token. The SEC’s report warns that:

those who participate in an unregistered offer and sale of securities not subject to a valid exemption are liable for violating Section 5.

This means that a family office that buys a token subsequently found to be a security may not be able to resell it. That SEC’s pronouncement is just one of a number of considerations that are in play when reselling instruments that may be deemed to be unregistered securities.

Conclusions

Recommending a new token should require the same analysis as recommending an investment in the token’s developer. Among other things, a family office or adviser must understand the blockchain community, the ever-evolving token market and the token’s prospects for achieving its use case. If an adviser would not think of recommending a start-up venture based solely on the limited information available in a white paper, then he should probably not recommend the newly offered token. Moreover, if you would have an attorney advise you as to the terms of any venture, then you should have an attorney with experience in the token market review any token as well.

]]>https://www.assetmanagementadvocate.com/2017/09/family-offices-and-the-madness-of-crowdsales/SEC Offers More Guidance on Cybersecurity Best Practices and Pitfalls – Part 2 of 2http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/p1JZNnPWyAY/
Fri, 18 Aug 2017 14:44:11 +0000https://www.assetmanagementadvocate.com/?p=1413Continue Reading]]>This post continues our discussion of the Risk Alert released on August 7, 2017, by the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) regarding conclusions drawn from its yearlong review of the cybersecurity practices of 75 asset management firms and funds. The sweep, deemed OCIE’s Cybersecurity 2 Initiative, covered broker-dealer, investment adviser, and investment company practices during the period from October 2014 through September 2015.

Elements of Effective Policies and Procedures

The Risk Alert identifies the elements of policies and procedures that the OCIE staff believes should be part of a “robust” set of cybersecurity controls. In addition to the major elements of a healthy cybersecurity program discussed in part 1 of this blog, the OCIE staff in the Risk Alert urges asset management firms to also consider the following critical elements.

Maintenance of prescriptive schedules and processes for testing data integrity and vulnerabilities.

Firms with cybersecurity policies and procedures that the OCIE staff found to be strong conduct vulnerability scans of core IT infrastructure to aid in identifying potential key system vulnerabilities, and maintain logs of prioritized action items for any identified concerns.

Policies and procedures that the OCIE staff support call for appropriate patch management policies that include (i) beta testing of patches with a small number of users and servers before firm-wide deployment, (ii) an analysis of the problem each patch is intended to fix, (iii) the potential risks in applying the patch, and (iv) the method to be used in applying the patch.

Established and enforced controls to access data and systems.

Robust programs require and enforce restrictions and controls for mobile devices connected to firm systems, such as password protection and the use of encrypted communication.

Firms with strong cybersecurity policies and procedures require third-party vendors to periodically turn over logs of their activity on the firm’s networks and require immediate termination of access for terminated employees, and very prompt (typically, same day) termination of access for employees leaving voluntarily.

Mandatory employee training.

The OCIE staff is supportive of firms that make information security training mandatory for all employees, both upon initial hire and then periodically, and of firms that institute policies and procedures to ensure that employees complete the mandatory training.

Engaged senior management.

Healthy cybersecurity programs identified by the OCIE staff require their policies and procedures to be vetted and approved by senior management.

Key Takeaways

Cybersecurity remains a paramount concern of the SEC, appearing on OCIE’s 2017 Examination Priorities list. This most recent Risk Alert comes as well-publicized cyber attacks have demonstrated that even the strongest IT system can be vulnerable to cybersecurity issues. It also comes as the cybersecurity consulting and insurance industries continue to expand, with greater capacity than ever before.

Asset management firms and fund boards should take advantage of the guidance offered by the OCIE staff in the Risk Alert to reassess their cybersecurity policies and procedures in this environment. Simply having such policies and procedures in place, the Risk Alert makes clear, is not enough, and OCIE plans to “continue to examine for cybersecurity compliance procedures and controls, including testing the implementation of those procedures and controls at firms.”

To prepare for such examination, firms and fund board policies should work to make sure that their cybersecurity programs include actionable incident response plans that are executable by employees. They should seek to ensure that cybersecurity policies and procedures are reasonably tailored to the firm’s or fund’s actual operations such that they are followed in actual practice. This could be achieved through an independent assessment or regular reporting from appropriate IT personnel. The OCIE staff seems to view cybersecurity incidents not as matters of if, but when, and suggests that when an attack does occur, everyone, from the chair of the board to the entry-level employee, should be able to rely on a set of well‑developed, well-tested procedures on which they have been trained. The guidance offered in the Risk Alert should help in establishing such a robust cybersecurity program.

]]>https://www.assetmanagementadvocate.com/2017/08/sec-offers-more-guidance-on-cybersecurity-best-practices-and-pitfalls-part-2-of-2/SEC Offers More Guidance on Cybersecurity Best Practices and Pitfalls – Part 1 of 2http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/AExh3sN3zaw/
Tue, 15 Aug 2017 15:00:38 +0000https://www.assetmanagementadvocate.com/?p=1408Continue Reading]]>On August 7, 2017, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) released a Risk Alert summarizing its conclusions from a year-long review of the cybersecurity practices of a 75 firms — including broker-dealers, investment advisers and investment companies. The sweep, OCIE’s Cybersecurity 2 Initiative, ran from September 2015 to June 2016 and covered the review period from October 2014 through September 2015. It follows OCIE’s 2014 Cybersecurity 1 Initiative, during which the staff examined a different group of firms from January 2013 to June 2014. The Risk Alert that followed the first sweep was released in early 2015.

The focus of OCIE’s second sweep was asset management firms’ written cybersecurity policies and procedures and, critically, their implementation. While the Risk Alert acknowledges that cybersecurity preparedness has improved across the industry since the first sweep exam, it emphasizes that significant deficiencies persist. The Risk Alert identifies common elements of policies and procedures that the staff regards as robust controls. The Risk Alert also stresses that, going forward, OCIE will increase its review of firms’ implementation of appropriately-tailored policies; merely having well‑drafted policies “on the books” but not applied will not suffice.

Recurring Cybersecurity Issues

The Risk Alert discusses several areas of widespread deficiency that the OCIE staff believes can serve as guideposts for firms to improve their policies, procedures and practices. While nearly all of the 75 firms evaluated in the Cybersecurity 2 sweep had written policies and procedures addressing cyber-related business continuity planning and Regulation S-P, and most advisers and funds had specific cybersecurity and Regulation S-ID policies and procedures, a majority of firms had weaknesses, including that:

their policies “were not reasonably tailored,” providing only vague, general guidance, and did not correspond to specific procedures for employees to follow in implementing the policies;

they failed to adhere to, or in practice did not actually follow, key established policies and procedures, including:

mandatory annual customer protection reviews;

annual and ongoing reviews of security protocol appropriateness;

required employee cybersecurity training and disciplinary provisions for employees who disregarded such training; and

their policies generally did not provide clear and non-contradictory instructions, and instead were often inconsistent, such as with respect to remote customer access and investor fund transfer restrictions.

Additionally, the Risk Alert discusses concerns regarding firms:

using legacy operating systems that do not support new security patches;

conducting penetration tests but failing to fully remediate high-risk findings from those tests in a timely manner; and

failing to appropriately adhere to Regulation S-P.

Elements of Effective Policies and Procedures

The Risk Alert identifies the elements of policies and procedures that the OCIE staff believes should be part of a “robust” set of cybersecurity controls. The guidance offered in the Risk Alert is quite specific, detailing the major elements of cybersecurity policies and procedures firms should consider to improve their programs. The critical policy elements that the OCIE staff favorably identified during the Cybersecurity 2 sweep exam include the following.

Maintenance of an inventory of data, information, and vendors/service providers. Well-developed policies and procedures include complete inventories of data residing on a firm’s networks and classifications of the risks, vulnerabilities, data, business consequences and information regarding each third-party vendor/service provider used by the firm.

Penetration Tests. Policies and procedures should contain specific information necessary to review the effectiveness of the testing and security solutions.

Security Monitoring and System Auditing. Policies and procedures concerning a firm’s information security framework should include details related to appropriate testing methodologies.

Access Rights. Procedures should track requests for network access and include policies specifically address the modification of user access rights, including for employee hiring and termination and the changing of employee positions/responsibilities.

Reporting. Procedures should contain specific action plans, including the names of individuals to contact if sensitive information is lost, stolen, unintentionally disclosed or otherwise compromised.

Part 2 of this blog discusses additional cybersecurity program elements identified in the Risk Alert and suggests key takeaways from the guidance.

]]>https://www.assetmanagementadvocate.com/2017/08/sec-offers-more-guidance-on-cybersecurity-best-practices-and-pitfalls-part-1-of-2/The Financial Choice Act Aims to Help Angel Investorshttp://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/mPWQRHtzajs/
Wed, 05 Jul 2017 17:36:33 +0000https://www.assetmanagementadvocate.com/?p=1405Continue Reading]]>The proper treatment of angel investing groups under the Federal securities laws can be a vexing question. If it were appropriate to describe the angel investing group as a “company” as defined in Section 2(a)(8) of the Investment Company Act of 1940, and if the “company” were appropriately viewed as issuing interests or shares, then the angel investing group would have to seek to rely on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act and comply with the requirements of Regulation D under the Securities Act of 1933. Yet these views seem to beg the questions of who is giving investment advice to the “company” and who is acting as a broker in offering and selling interests in the “company.”

Regulatory Risks for Angel Investors

The status of angels (at least the investing type) is not a philosophical question. For example, if a choir of angels were treated as an investment company, Section 47(b) of the Investment Company Act would make voidable any contract the group entered into in violation of the Act. Possible violations of the Investment Advisers Act and other Federal and state securities laws, not to mention the applicability of the antifraud provisions in the 1933 Act and in Rule 10b-5 under the Securities Exchange Act of 1934, pose additional risks. Such risks cause angels to express serious concerns about the restrictions that appear to be imposed by those statutes.

The Proposed “HALOS” Act

Some of these concerns appear to have been heard by the House of Representatives, which added H.R. 79 as Subtitle K of the Financial Choice Act that has passed the House of Representatives and been sent to Senate. Section 1 gives this piece of legislation the charming name of “Helping Angels Lead Our Startups Act,” or the “HALOS Act.” The HALOS Act would require the SEC to amend Regulation D to permit the issuers relying on the regulation to participate in events sponsored by a:

government entity,

educational institution,

nonprofit organization,

angel investor group,

venture forum, venture capital association, or trade association, or

another organization determined by the SEC.

The sponsor must not: (a) refer to specific securities when advertising the event, (b) make investment recommendations, (c) become involved in negotiations with the issuer or (d) receive any compensation other than administrative fees. The issuer must limit its communications to:

the type and amount of securities offered;

the amount already subscribed for; and

the intended use of the proceeds.

Definition of “Angel Investment Group”

Although the HALOS Act would not define a venture forum or association, it does include a definition of an “angel investment group,” as any group:

Introduction of any newly defined terms provides an opportunity for practitioners to expand its application. In light of Congress’s clear intent to foster angel investing, adding “angel investor group” to the books may make it easier to request a no-action letter, order or even a regulation exempting such groups from the Investment Company and Investment Advisers Acts or from broker-dealer regulations. Meanwhile, in the interests of parallelism and certainty, it would be nice if Congress could, Federalism notwithstanding, require the various states to take the same positions that are articulated and implied by the HALOS Act.

]]>https://www.assetmanagementadvocate.com/2017/07/the-financial-choice-act-aims-to-help-angel-investors/Section 848 of the Financial Choice Act 2017: Unwise at any Speed (Conclusion)http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/f6dQI3wMdpw/
Tue, 16 May 2017 14:25:25 +0000https://www.assetmanagementadvocate.com/?p=1399Continue Reading]]>This series of posts has examined the misguided efforts of the House Financial Services Committee to reform the existing process for issuing exemptive orders pursuant to Section 6(c) of the Investment Company Act of 1940 (the “1940 Act”). The previous posts discussed the problems with the current process and why Section 848 of the pending Financial Choice Act of 2017 would make matters much worse. This concluding post considers the possibility that Section 848 may not accomplish anything and then discusses other possible reforms to the exemptive process that may prove more fruitful.

Working around Section 848

This isn’t the first time that Congress tried to impose a firm deadline on the SEC’s review of filings. Section 8(a) of the Securities Act of 1933 provides that:

[T]he effective date of a registration statement shall be the twentieth day after the filing thereof or such earlier date as the Commission may determine ….”

However:

If any amendment to any such statement is filed prior to the effective date of such statement, the registration statement shall be deemed to have been filed when such amendment was filed ….”

To avoid putting the SEC staff in a bind when they couldn’t meet the 20 day deadline, registrants began adding the following legend to their registration statements:

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective ….”

This practice was codified into Rule 473 in 1947. It basically turned a right into an option; a registrant can threaten to file an amendment without the legend if the review process becomes too protracted (and the SEC can respond by threatening to file a stop order).

As explained in the last post, Section 848 permits a 45 day extension of the review period with the applicant’s consent. One could imagine such a consent becoming standard in every initial application. Applicants might even start adding a legend that the application will be deemed to be continually resubmitted, so as to continually restart the 45 day review period. This may be the best one could hope from Section 848—that it would become a last resort for an applicant after an unconscionable delay responding to an application.

In Fairness

Section 848 raises a point that deserves more thoughtful analysis. As it presently exists, the administrative process for issuing exemptive orders is not perfect, and it can be very frustrating and disappointing for an applicant that believes it fully deserves the exemptive order that it has sought. Here are some other reforms that may be worth serious consideration—

The SEC Chair could formally task the Division of Investment Management (the “Division”) with internal deadlines for reviewing and commenting on exemptive applications (no more than X days from receipt), and could make certain that the relevant appropriations legislation contained appropriate amounts of money fully and properly staffing this aspect of the Divisions overall responsibilities in administering the 1940 Act. Application fees could be charged to offset increased appropriations.

The SEC could adopt procedures specifically for hearing objections to proposed orders or denials of applications. Once standing is established, objectors should be permitted to submit briefs directly and applicants should be permitted to respond. The SEC staff could then make their actual policy recommendations to the SEC, rather than trying to cast objections in their best light.

The SEC Chair could engage with the Division to properly prioritize and re-prioritize its tasks on a regular basis so that the projects with the greatest consequences, in terms of most immediate effect on investor protection, would get expedited to the front of the line, while the least deserving would be deferred. The Division could be required to report monthly to the SEC Chair on its progress in meeting its deadlines, and the SEC Chair could be required to report to its Congressional oversight panels. Such an express oversight process by the SEC Chair and the Congressional oversight panels would give the industry several touch-points for commenting on, or even disputing, resource allocation and responsiveness issues.

Finally, any reforms should extend to every provision in the 1940 Act that permits the SEC to exercise exemptive authority. (The temporary exemption provided by Rule 6b-1 for applications filed by employee securities companies could be excluded because they don’t raise the policy and shareholder protection issues raised in Section 6(c) applications.)

]]>https://www.assetmanagementadvocate.com/2017/05/section-848-of-the-financial-choice-act-2017-unwise-at-any-speed-conclusion/Section 848 of the Financial Choice Act 2017: Unwise at any Speed (Part 4)http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/jHnaZiYRWVk/
Mon, 15 May 2017 15:41:33 +0000https://www.assetmanagementadvocate.com/?p=1391Continue Reading]]>This series of posts examines the misguided efforts of the House Financial Services Committee to reform the existing process for issuing exemptive orders pursuant to Section 6(c) of the Investment Company Act of 1940 (the “1940 Act”). My first three posts discussed the current exemptive process and some of its significant shortcomings. This post discusses the changes to the process proposed in Section 848 of the pending Financial Choice Act of 2017 and why these proposed changes would undermine investor protections provided by the 1940 Act. It is difficult to overstate what bad public policy Section 848 represents.

Proposed Changes to the Exemptive Process

Section 848 would amend Section 6(c) to require that every application be published on the SEC’s website within 5 days after receipt. The SEC would have 45 days after receipt of an application to give substantive comments and request that the application be resubmitted (restarting the review period), otherwise the application would be deemed to have been approved. Both the SEC and the applicant have the right to extend the review period for an additional 45 days.

If the SEC were to deny the application, the applicant would have 20 days in which to request a hearing, with the hearing to commence within 30 days after the denial. An application that is neither approved, denied, or set down for a hearing during those time frames would be deemed to have been approved. It is not clear why Section 848 singles out Section 6(c) to the exclusion of the other instances of exemptive authority that the SEC possesses like Section 17(b) of the 1940 Act or Section 206A of the Investment Advisers Act.

An Unfunded Mandate

If one was actually trying to make proposed Section 848 function properly, it should be accompanied by an appropriation that would permit the SEC to hire, let’s say, another 100 lawyers whose sole task would be to review applications that are filed under Section 6(c). In addition to being experts in Section 6(c), those lawyers would also have to be capable of mounting an effective case during the subsequent hearing before an SEC administrative law judge (ALJ).

If such an appropriation does not accompany Section 848, then the SEC will have to find those resources amongst its existing staff in the Division of Investment Management (the Division) and Office of General Counsel, i.e., Section 848 will be an unfunded mandate but come with statutory deadlines. That means that an applicant with a bad product, or raising serious investor protection concerns, will be pushed to the head of the line, ahead of every other possible investor protection project to which the SEC staff is already committed. That is like to occur because the alternative–allowing any crackpot idea be deemed to be issued an order by lapse of time–will be wholly unacceptable. This would be especially problematic if the reason that the SEC staff is already fully committed to other projects is, for example, attempting to propose and adopt rules or conduct studies that are mandated by the Dodd-Frank Act. It is very hard to understand why an application filed by any single applicant is inherently, in every possible instance, obviously more important and more deserving than any other provision in a statute enacted by Congress.

Subverting the 1940 Act

Perhaps at least as importantly, Section 848 reverses the normal statutory presumption that any transaction that is prohibited by one or more sections of the 1940 Act would pose unacceptable risks for investors and would not be in the public interest. Congress intended that such transactions would occur only if the SEC was able to make those very important findings and issue the exemptive order being sought. Read in that light, Section 848 takes on the flavor of an entitlement: any applicant who is able to file an application will be exempted from those important prohibitions if the Division cannot react promptly within the time frames indicated.

Subverting Due Process

As explained in the first and third posts, the current process allows someone affected by the proposed exemption (an “objector”) to request a hearing before an ALJ on the application. The myopic focus of Section 848 on the applicant’s right to a hearing fails to consider this right of potential objectors. If the SEC must complete the process in 45 to, at most, 90 days, how much time could be left for potential objectors to be notified of a proposed order and prepare a proper request for a hearing?

Section 43(a) of the 1940 Act also permits an objector to challenge an exemptive order in a U.S. Circuit Court of Appeals. Section 43(a) provides, however, that an objector cannot object on any grounds that were not urged before the SEC, although the objector can petition the U.S. Circuit Court of Appeals to allow it to adduce additional evidence. The curtailed timeframe of Section 848 would make it difficult for anyone to establish grounds for review on a timely basis. Even if the court permits additional evidence, this kind of motion practice–which generally occurs before a sitting judge in a trial court before, during, and after the trial has occurred–would have to occur in what are some of the busiest appellate courts in the Federal judiciary.

]]>https://www.assetmanagementadvocate.com/2017/05/section-848-of-the-financial-choice-act-2017-unwise-at-any-speed-part-4/Distribution in Guise Settlement Orders Reinforce Need for Better Compliance, Contracting, and Disclosure Practices (Part 2)http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/9H4RShJvnvc/
Thu, 11 May 2017 18:41:23 +0000https://www.assetmanagementadvocate.com/?p=1388Continue Reading]]>This post continues our discussion of the settlement orders that the SEC recently entered into with investment advisory firms based in Chicago (the “First Order”) and Maryland (the “Second Order”). These cases illustrate that the SEC remains focused on mutual fund distribution issues and teach some hard lessons about the importance of compliance oversight, contracting, and disclosure around distribution and sub-transfer agency (“sub-TA”) payments.

The improper payments detailed in the First Order were discovered by the firm during an internal review conducted after it knew that the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) would be examining its intermediary payments. According to the First Order, “After identifying the payment errors, [the adviser] promptly notified the Board, reimbursed the Funds with interest, and supplemented its practices of providing oversight of payments to financial intermediaries.”

But these two recent distribution in guise enforcement cases, together with the first one brought in connection with OCIE’s sweep exam that was settled in 2015, show that liability may be present even where mitigating factors exist, such as a firm and fund board undertaking due diligence and reviewing and/or remediating misclassified payments. Moreover, while press reports suggest that the First Order and the Second Order may represent the end of enforcement follow-up from the distribution in guise sweep exam, distribution and intermediary payments continue to be an OCIE priority. An ounce of prevention is worth a pound of cure when it comes to mutual fund distribution payments, and the following are some observations that can be drawn from the Orders for best practices going forward.

Compliance and Contracting Practices

As we have commented before, offense is often the best defense. Carefully drafted agreements that clarify the services to be provided by and the sources of compensation to be paid to intermediaries are a key element to avoiding payment for distribution outside of a Rule 12b-1 plan. Care should be taken to negotiate with each intermediary contractual provisions that specify which services are primary intended to result in the sale of fund shares (distribution services), which fees will be used to pay for distribution services, and which fees will be paid for sub-TA services, if any. Separate and auditable contracts and payment streams are likely to avoid the type of misclassification that plagued the Chicago firm in the First Order. But as both Orders underscore, even when contractual language is relatively clear (regarding, for example the source of revenue share payments due to an intermediary), failure to abide by contractual terms may put a firm in violation of Section 12(b) of the Investment Company Act of 1940 (the “1940 Act”).

Advisers and fund boards should act now, if they have not already, to assess their financial intermediary arrangements in light of the recent Orders and the SEC’s 2016 Distribution in Guise IM Guidance Update. Such an assessment should, among other things: take into account all factors identified in the Guidance and the Orders; seek to identify any sub-TA fee payments made above board-approved and disclosed limits; scrutinize any outlying payments by the adviser to intermediaries; focus on identifying any discrepancies between fund disclosures and sub-TA fee payment practices; provide for the refunding of any improper payments to affected funds; and require the development and implementation of control procedures and enhancements to correct any identified shortcomings.

Fund Disclosures

In both Orders, liability for the actual violations was compounded by the low-hanging fruit of inaccurate disclosure. The good news is that the disclosure in question appeared fairly broad and in line with industry standards, and no findings were made with respect to its inclusiveness or the actual fee levels (which in the case of the Maryland firm were relatively high). Instead, the Orders focus on specific inaccuracies, emphasizing the importance of establishing controls to ensure that limits set in disclosure are carefully adhered to.

Nature of Payments

The Orders do not shed light on whether certain services may or may not be “primarily intended to result in the sale of shares” within the meaning of Rule 12b-1 under the 1940 Act. Liability is far more likely to result where there has been a clear misapplication of payments. Of note, agreements in both Orders suggest some “bundling” of revenue share payments in a single contract with Rule 12b-1 and sub-TA payments. Also, consistent with the Guidance, the Orders do not identify issues with common arrangements whereby funds pay sub-TA fees to their advisers as reimbursement for fees paid to intermediaries for bona fide non-distribution services and pay different rates, under different agreements, for different levels of sub-TA services provided to different types of funds distributed in different distribution channels. The Orders also did not challenge the use of a firm’s own assets to pay for distribution services (i.e., revenue sharing).

]]>https://www.assetmanagementadvocate.com/2017/05/distribution-in-guise-settlement-orders-reinforce-need-for-better-compliance-contracting-and-disclosure-practices-part-2/Section 848 of the Financial Choice Act 2017: Unwise at any Speed (Part 3)http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/pXAtDCamBz4/
Thu, 11 May 2017 18:22:52 +0000https://www.assetmanagementadvocate.com/?p=1382Continue Reading]]>This series of posts examines the misguided efforts of the House Financial Services Committee to reform the existing process for issuing exemptive orders pursuant to Section 6(c) of the Investment Company Act of 1940. Section 848 of the pending Financial Choice Act 2017 would attempt to accelerate the process of obtaining exemptive orders by forcing the SEC to grant or deny an exemptive application within a fixed time frame. My first post discussed the current process of obtaining an exemptive order. This post examines a problem overlooked by proposed Section 848, perhaps due to the Committee’s limited understanding of the exemptive process.

Shortcomings of Hearings

Recourse to a hearing before an SEC administrative law judge, typically in response to an objection to the proposed exemptive order, is not well suited to achieving a thorough and wise regulatory analysis of an exemptive application. The author has personally been involved in a number of SEC administrative hearings, including the money market fund amortized cost hearings in 1979-1980, the Narragansett Capital hearings in the mid-1980s, and the TIAA-CREF hearings from 1987 to 1989. Each of those hearings involved serious public policy questions—not questions of fact or of witness credibility—that were especially challenging for the SEC administrative law judge (ALJ).

Where an aggrieved person (an “objector”) requests a hearing in response to a notice of a proposed exemptive order, the SEC engages in a process of determining whether the objector has standing and has raised an issue that is germane to the proposed order. A petition from a person determined not to have standing is dismissed, as is a petition raising issues that are not germane to the exemptive order. These decisions are made by the SEC itself, not by the Division pursuant to delegated authority, and prevent the SEC, like any other adjudicative tribunal, from being tied up by frivolous requests from persons who are abusing the statutory process.

Even if the SEC orders a matter be set down for a hearing, the Rules of Practice were designed to handle contested evidentiary proceedings, not broad questions of public policy. For example, in a hearing the Division of Investment Management is deemed to be a party and the applicant is deemed to be a party, which gives both of them procedural rights not enjoyed by the objector. The SEC administrative law judge may allow an objector to participate in the hearing, but this would be a matter of grace, not of right.

Moreover, once the matter is set down for a hearing the Division assumes the role of the right honorable opposition and the applicant is left to defend its application against the protestor and the Division. While that may be the correct role for the applicant to assume, it puts the Division in a difficult position since it may or may not have any sympathy for the position(s) taken by the objector. As a result, a hearing may not result in vigorous advocacy of all sides of an issue. In any event, the arguments will be directed at an ALJ who is supposed to implement, not establish, broad SEC regulatory policies.

]]>https://www.assetmanagementadvocate.com/2017/05/section-848-of-the-financial-choice-act-2017-unwise-at-any-speed-part-3/Distribution in Guise Settlement Orders Reinforce Need for Better Compliance, Contracting, and Disclosure Practices (Part 1)http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/5p_HGxBU2w4/
Wed, 10 May 2017 20:16:06 +0000https://www.assetmanagementadvocate.com/?p=1376Continue Reading]]>In two back-to-back enforcement cases arising from the SEC’s now four-year old distribution sweep exam, a Chicago-based mutual fund adviser has agreed to a $4.5 million civil money penalty and a Maryland-based firm has agreed to pay disgorgement of $17.8 million plus $3.8 million in interest and a $1 million penalty. Both cases reinforce the importance of compliance oversight, contracting, and disclosure around distribution and sub-transfer agency (“sub-TA”) payments. This post will review the findings in each case (which the firms neither admitted nor denied). A subsequent post will recommend steps to mitigate the risk of improper distribution payments.

First Settlement Order

The settlement order in the Chicago case (the “First Order”) details three separate sets of violations. In the first, the firm was found to have negligently used approximately $902,000 in fund assets outside of a board-approved Rule 12b-1 plan to pay for marketing and distribution services provided by third party financial intermediaries. The improper use of fund assets occurred when the firm “inadvertently misclassified [revenue sharing] agreements as being for sub-TA services and caused the funds to pay for those services outside of a Rule 12b-1 plan for approximately two years.”

In the second set of findings, the fund’s board had imposed caps on “the amount of fees to be paid out of fund assets to each intermediary for sub-TA services,” which in turn were disclosed in the funds’ prospectuses. The funds were to reimburse the firm for its actual sub-TA payments up to the caps. However, due to operational errors in calculating the fees payable under sub-TA agreements with two intermediaries, fund assets were used to reimburse payments of approximately $356,000 in excess of the caps. In addition to reducing the net asset value of the funds by $1.25 million, the First Order states that both sets of conduct were contrary to the funds’ disclosures with respect to the source of payment for distribution and sub-TA services and the requirement to cap fees.

Finally, the Chicago firm had arrangements in place under which it provided certain shareholder administrative services to particular fund share classes. The firm indicated that it would contract with various intermediaries to perform the services and represented to the board that the fees would not be retained by the firm, “but would rather be passed through to the various financial intermediaries providing these administration services.” In fact, the First Order states, the firm provided the services itself and pocketed the fees.

Second Settlement Order

The SEC findings in the settlement order regarding the Maryland firm (the “Second Order”) were similar. There, the findings involved the “improper use of mutual fund assets to pay nearly $18 million for the distribution and marketing of fund shares outside of a written, board-approved Rule 12b-1 plan, as well as to pay expenses in excess of the mutual funds’ expense caps” that did not comply with the funds’ prospectus disclosures.

Agreements with certain intermediaries described in the Second Order called for the provision of distribution and marketing services that the distributor was to pay for with fees “from its own resources.” The Maryland firm, however, was found to have treated the agreements as being for sub-TA services and to have “improperly caused the funds to pay approximately $14.87 million for those services outside of a Rule 12b-1 plan.” The funds also paid intermediaries approximately $2.96 million for sub-TA services in excess of an annual 30-basis-point expense limitation. In addition to violating prospectus disclosures, the Maryland firm was found to have made inaccurate disclosures to the fund board concerning the payments.

Part 2 of this blog will discuss lessons learned and best practices arising from these cases.

]]>https://www.assetmanagementadvocate.com/2017/05/distribution-in-guise-settlement-orders-reinforce-need-for-better-compliance-contracting-and-disclosure-practices-part-1/Section 848 of the Financial Choice Act 2017: Unwise at any Speed (Part 2)http://feeds.lexblog.com/~r/AssetManagementAdvocate/~3/1rxx1_ecPrQ/
Wed, 10 May 2017 13:35:26 +0000https://www.assetmanagementadvocate.com/?p=1370Continue Reading]]>This series of posts examines the misguided efforts of the House Financial Services Committee to reform the existing process for issuing exemptive orders pursuant to Section 6(c) of the Investment Company Act of 1940. Section 848 of the pending Financial Choice Act 2017 would attempt to accelerate the process of obtaining exemptive orders by forcing the SEC to grant or deny an exemptive application within a fixed time frame. My prior post discussed the current process of obtaining an exemptive order. This post examines the problem at which Section 848 appears to be aimed. A later post will explain why it misses its mark.

Long Delays When Seeking Exemptions

Every practitioner in this area can recite examples of long waiting periods, sometimes stretching into years, for a decision from the SEC staff. Such a delay can have highly adverse competitive effects on an applicant. In general, there are at least three reasons for these delays.

First, many applications raise novel policy issues that need to be carefully thought through by the SEC staff and the commissioners. The public interest and best means of protecting investors may not be as obvious as the applicant may believe, so it often takes time to for the Division of Investment Management (Division) to reach a decision on whether to grant the order and, if so, on what conditions to attach. In addition, reflecting on earlier exemptive orders may prompt the SEC staff to reconsider policies as they address subsequent applications seeking the same exemptions. It would be irresponsible for the SEC not to learn from what it has done and to make adjustments accordingly.

Second, the ability to issue exemptive orders on a serial basis ironically undercuts the incentive the SEC has to reduce the number of applications, and thus its workload, by adopting rules providing exemptions that would be available to a broad class of potential applicants. Many exemptive orders that have been granted serially (such as ETFs and inter-fund lending) have become so routinized that they are ripe for rulemaking. (Indeed, an ETF rule was in fact proposed but never adopted.) But codification of exemptive applications often takes a back seat to what are perceived as more urgent matters (such as money market fund reform or liquidity risk management) the SEC cannot address through the individual exemptive order process. Senatorial foot dragging on confirming commissioners has also impeded the rulemaking process.

Finally, individual exemptive applications must be reviewed and vetted by different levels of staff within the Division, who may have to consult with other Offices or even Divisions, and who may not all agree about the nature or scope of the exemptive relief being sought. This “socialization” process within the Division necessarily slows the progress that any individual exemptive application can make, but, in light of the profound policy and competitive implications of granting exemptions from statutory prohibitions, it is important for the SEC to exercise disciplined oversight over its exemptive authority. If the alternative was to give an individual staff member unchecked power to rescind portions of the 1940 Act based on his or her own judgment, the result would be chaotic, unpredictable, and unfair, even if one were to assume that no serious damage was being done to investor protection.